TACOMA, Wash. (HedgeWorld.com)–Strong demand for hedge funds from U.S. and international pension funds helped Frank Russell Co.’s Russell Investment Group double its hedge fund assets under management in 2003 to more than US$2 billion.

Dave Tsujimoto, director of alternative investments at Russell, said greater demand among institutional investors–particularly pension funds–for consistent, low-volatility performance has increased assets under management in Russell’s fund of funds program.

It’s also made finding quality managers more difficult, he said.

“Sourcing managers is a big challenge hedge fund investors face today because there’s so much money flowing into the area,” Mr. Tsujimoto said.

That money is coming not just from U.S. plan sponsors but from pension funds in Japan and Europe, as well. According to a 2003 survey of institutional investors conducted jointly by Frank Russell and Goldman Sachs International, London, the number of North American respondents that invested in hedge funds in 2003 increased by 40% over 2002.

In Europe, the number of respondents investing in hedge funds in 2003 more than doubled from 2002, and more than one-quarter of respondents said they intended to launch new hedge fund allocation programs in 2004, according to the survey.

In Japan, the average allocation to hedge funds increased by 2.5 percentage points in 2003, and 41% of institutions reported some kind of hedge fund allocation, up from 30% in 2002. Overall commitments to hedge funds by Japanese investors reached US$2 billion, an increase of US$1.3 billion from 2001.

Mr. Tsujimoto said he expects continued growth in hedge fund investments in 2004 but not because hedge funds are poised to outperform traditional markets. Equity returns this year will be positive but will not approach the return levels seen in 2003, he said. Continued low interest rates will keep bond yields low.

Although hedge funds’ risk-return profiles will still look good compared to traditional markets, Mr. Tsujimoto said returns would be harder to come by as more capital flows into the strategy. Good managers will be closing, and investors will find they have to invest in new managers earlier in their life cycle.

This will not lead necessarily to more risk but will likely introduce new kinds of risk. For example, investors in younger hedge funds are betting more on the manager than the strategy, which leads to so-called “key person” risk. Also, without proven business processes younger funds also face a greater “small business risk” of failure, Mr. Tsujimoto said.

“But on the flip side, often the big established large firms, because of their asset size, tend to be in similar trades with other large hedge funds,” Mr. Tsujimoto said, thus increasing their “herd risk,” or risk of being dragged down along with everyone else if a particular trade goes bad because they are too big to get out of the trade quickly.

CClair@HedgeWorld.com